dilution, liquidation preference and $$$ with benefits. don’t sign a bad deal.
Jeff Bezos talking about Amazon's seed round: “it was the hardest thing I've ever done.” in 1995, Bezos pitched Amazon to 60 investors, explaining what the Internet was and warning of a 70% chance of failure (brave of him). 40 said no. 22 angels wrote $50K checks, raising $1M for 20% of Amazon at a $5M valuation. wild? maybe.
the reason is simple: you're giving away equity at the lowest possible valuation, before you've proven anything. every percentage point at pre-seed costs you a fraction of a cent on the dollar compared to what that same point represents at series B. cheap equity is precisely when you should be most protective of it.
this is also why the structure of early rounds matters so much. a SAFE with a low cap and no discount is a very different instrument than one with aggressive terms. founders who don't read the fine print often discover at their series A conversion that their effective dilution was much higher than the headline percentage suggested. and your early stage investors are getting diluted, too. so you have to be thoughtful of those pro-rata rights that give early investors the ability to participate in future rounds.
so, what dilution is an ok dilution? I’m adding Carta’s benchmarks again - the guys have a pool of 5k+ US-based startups to make the stats speak for themselves:
ok, dilution might look simple - everyone thinks about how to sell less equity on better terms. now the question: those better terms, what are they, exactly? please meet something called liquidation preference - if it’s your first raise, you can’t spend enough time learning about it.
in simple terms, liquidation preference is basically a rule that says:
"if the company is sold, investors get their money back before founders and employees get theirs."
if the company sells for $500M, liquidation preference usually matters very little. but if it sells for $10M after raising $8M, it matters a lot. let’s take a look at a few examples:
1. a good exit:
you raise $2M from an investor → they receive a 1x liquidation preference → later, the company is sold for $10M.
the investor has a choice:
- use their liquidation preference and take their $2M first
- convert their preferred shares into common shares and take their ownership percentage instead
suppose they own 20%.
20% of $10M = $2M.
so either way, they get $2M. good. safe. everyone’s happy.
2. a bad exit:
same deal: $2M invested → 1x liquidation preference at 20% ownership → but the company sells for only $5M.
the math without liquidation preference:
investor: 20% = $1Meveryone else: $4M
but the investor invested $2M, so their 1x liquidation preference kicks in.
investor: $2M
everyone else: $3M
that's the closest thing to ‘insurance’ investors are buying when they put that liquidation preference in your term sheet. we are still on really founder-friendly terms here.
3. a fantastic exit:
same deal, but you sell the company for $100M.
taking the liquidation preference would give the investor just $2M.
converting to common shares gives them:
20% x $100M = $20M
obviously, they choose $20M.
this is why a standard 1x non-participating liquidation preference usually isn't particularly scary. it mainly protects the investor against disappointing exits, and that’s ok. let’s now take a look at less founder-friendly terms (please negotiate yourself out of it).
4. a nasty exit:
imagine you raise $5M with a 2x liquidation preference → the company later sells for $12M.
investor gets up to:
$5M x 2 = $10M
that leaves only $2M for founders, employees and other common shareholders.
even though the company sold for $12M.
so now you will know why “exited founder” is not the whole story.
5. a total nightmare exit:
there's an important distinction to introduce:
1x non-participating → investor gets either their investment back or their ownership percentage.
vs.
1x participating → investor gets their investment back and then participates in what's left according to their ownership.
an example:
company sells: $10Minvestor invested: $2M at 20% ownershippreference: 1x participating
first, investor takes $2M.
$8M remains.
then the investor also gets 20% of the remaining $8M = $1.6M (participating rights).
total investor proceeds = $3.6M.
yeah, feels painful, I know. again, it’s worth to invest time into understanding those terms before you sign a single term sheet.
think of an exit as a queue for money:
exit money → investors with liquidation preferences → common shareholders. so, “I sold for $10M” always means very different outcomes for a founder.
and now back to dilution again: we are taking money with the idea in mind that we are not the first ones to get paid at the event of exit. so, what makes a good deal, really?
e.g., how about taking a Y Combinator’s deal with 7,5% dilution for $500k? THAT doesn’t sound good at all, right?
dilution vs. value creation: money is not everything that matters about VC $$$.
as you might have guessed from the subheader, the real question is not "how much did I give up?" but "did giving up X% return more than X% in startup value?" if a VC's network, brand, or operational help 5x'd your outcome, the dilution was cheap. if they were a passive check and you could have grown organically = it was expensive.
did selling additional %% of the company mean you’re losing control over board and voting rights? could you raise less to get less dilution if so? dilution is only bad relative to what it bought you.
back to the YC example: no one is massively pleased with the offer of $500k for the 7,5% of your startup. it’s the opportunity founders are after: YC badge = credibility for customers, a foot in the door with a huge pool of investors, and a massive peers’ network. nothing to do with the $500k check really.
another good example of good money wired your way might be Athletic Ventures - they invest AND bring elite athletes visibility and network to boost their portfolio companies GTM motion. that’s the case for d2c brands mostly - they are getting $$ + an extra value.
(that’s not a recommendation or an ad integration - not a single $ was paid and now I’ll be thinking about it till tomorrow probably).
alright ladies and gents, I genuinely hope I didn’t scare you too much and you’ve just learned something useful from this issue. please consider forwarding it to a fellow founder if so, you might save them from a huge trouble of building for years and walking away from nothing.